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Unformatted text preview: 1 1 2 The model in equation (1) is called the discounted freecash flow approach. In the 3 model, free cash flow represents the net cash generated by operations after preferred dividends and cash investment in operations, or the amount that is ‘free’ to be distributed to common shareholders. Don’t be frightened by the math. The equation says that that P , the price which the market assigns to a company’s stock currently (at time t = 0), equals the present value of a stream of expected future free cash flows per share of stock discounted at a rate of r. The discount rate r, known as the equity cost of capital , reflects the riskiness or uncertainty of the future cash flow stream and t reflects the timing of the cash flow. The model uses current cash flow, which is known with certainty, to estimate unknown future cash flows. Companies frequently use this model to conduct goodwill impairment tests. The model in equation (2) links stock price and accrualbased earnings by using 4 earnings to forecast future cash flows. Empirical evidence shows that stock returns have higher correlation with accrual earnings than with operating cash flow. And current earnings outperform current cash flows in predicting future cash flows. One reason is that current accrual (GAAP) earnings are more forwardlooking than...
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 Fall '10
 GOOCH
 Dividends, Generally Accepted Accounting Principles, future cash flows

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